Tuesday, November 1, 2011

Some general government debt developments

Back in May, Morgan Kelly snapped us out of a Saturday morning stupor with another thought-provoking article in The Irish Times. Among many topics the issue of Ireland’s public got an airing.

Irish insolvency is now less a matter of economics than of arithmetic. If everything goes according to plan, as it always does, Ireland’s government debt will top €190 billion by 2014, with another €45 billion in Nama and €35 billion in bank recapitalisation, for a total of €270 billion, plus whatever losses the Irish Central Bank has made on its emergency lending. Subtracting off the likely value of the banks and Nama assets, Namawinelake (by far the best source on the Irish economy) reckons our final debt will be about €220 billion, and I think it will be closer to €250 billion, but these differences are immaterial: either way we are talking of a Government debt that is more than €120,000 per worker, or 60 per cent larger than GNP.

This €250 billion projection was immediately latched onto and generated some articles in response from Murphy and Leddin & Walsh. In both cases the €250 billion estimate was said to be the result of “double-counting” and other errors.

However, I think the Kelly analysis is technically correct but is inflated by some overly pessimistic assumptions. It may seem like this is going over old ground but it does give a starting point to summarise the debt developments that have occurred since May.

Up to today it was believed that the general government debt at the end of 2010 was €148 billion. From the four-year National Recovery Plan (page 110) the planned general government deficits for the years 2011 to 2014 were forecast to be €15 billion, €12 billion, €10 billion and €5 billion. These are exclusive of any banking costs. Adding these deficits for 2011-2014 to the 2010 debt of €148 billion brings us to the €190 billion starting point of Morgan Kelly. There is no double counting of bank-related sovereign debt.

These deficits were revised up in April’s Stability Programme Update (page 50) by a cumulative €8 billion to a total of €50 billion. The reduction in the interest rates on our EU loans will have brought this down again and this is likely to be reflected in the revised macroeconomic projections to be released by the Department of Finance on Friday. Of course the starting point in 2010 was reduced by just under €4 billion as a result of a real double counting error in the Department of Finance. Between the ups and downs it looks we are looking at a 2014 debt of around €190 billion before we start adding bank-related debt.

Thus far, this is equally as pessimistic as Morgan Kelly so we better inject some optimism into proceedings. From €190 billion he adds €35 billion for bank recapitalisation and €45 billion for NAMA. While these figures have an actual basis (and were used in the original Namawinelake estimate) it is now commonly accepted that they will not be simple additions to our government debt.

The €35 billion figure was the “worst-case” contingency amount set aside to recapitalise the banks as part of the EU/IMF programme. As we know the actual recapitalisation amount was €24 billion as revealed in the March PCAR announcement. As a result of haircuts to junior bondholders in the banks and some private sector involvement the portion to be covered by the State was around €17 billion.

Of this, €10 billion came from the further destruction of the savings built up in the National Pension Reserve Fund so will not add to our debt. Although we poured €17 billion into the banks this year, only €7 billion of this is to be added to our debt as €10 billion came from our existing resources.

Some of the money not used will be diverted to the credit union sector where it is anticipated that up to €1 billion could be used to prop up ailing credit unions. This will add to the general government debt.

The official general government debt (GGD) measure excludes NAMA so we are now looking at a 2014 GGD of around €198 billion. Using the IMF’s nominal GDP forecast for 2014 of €174 billion this would put the debt-to-GDP ratio at 114%, and it is projected to fall from that point on. This does not account for three assets that will also be on the balance sheet:

€3 billion of contingent capital provided to the banks to be returned in 2014.

Possible resale value of the banks (AIB, PTSB and 15% share in BOI)

It is hard to put a value on the banks and hopefully the view that they have “moved from being a liability to an asset on Ireland’s balance sheet” will gain a greater foothold. It is easy to suggest that the above four items would reduce Ireland’s net debt to GDP ratio to below 100%. If you prefer GNP as the appropriate measure of the Irish economy we are probably looked at a net debt to GNP ratio in 2014 that will be less than 125%. Large but not terminal.

The €45 billion figure for NAMA was the estimated total if all property and construction loans of more than €5 million in the participating banks (AIB, BOI, EBS, Anglo and INBS) were transferred to NAMA. As we know the transfer of developer loans above €20 million was completed. In total NAMA bought about €72 billion of these loans and paid €31 billion for them. The loans of less than €20 million were never transferred to NAMA and the expected losses on these were included in the PCAR analysis undertaken by BlackRock Consultants as part of the stress tests so have been accounted for.

It is impossible to know what the final outcome of the NAMA process will be. NAMA did create €31 billion of bonds to buy the developer debt, but it bought assets which also had a notional value of €31 billion as valued in November 2009. If these levels were to be maintained beyond the November 2009 valuation date, NAMA would have no effect on our net debt position.

Of course, property prices have not been unchanged since November 2009 and they have tumbled onward ever downward. The excellent Namawinelake (the “best source on the Irish economy” remember!) estimates that the value of property backing the loans has fallen by a further €6 billion since the NAMA valuation date.

It is impossible to use this as a projection of possible NAMA losses. In most cases NAMA has control over the loans and not the assets. NAMA has been making substantial disposals for the past few months but we are not told if the agency is making a loss or even possibly a profit on these transactions.

NAMA has the potential to make a call on the State’s resources to cover a shortfall on its operations. Unless there is almost complete collapse in asset values it is hard to see how this shortfall could be more than €10 billion, and it is likely to be substantially less than that.

It is not clear that there will be losses on the Emergency Liquidity Assistance (ELA) provided by the Central Bank of Ireland. The banks have been provided with sufficient capital to absorb the losses on their loan books so they should be able to repay the central bank liquidity. In fact the chief executive of the biggest user of ELA has said that the State is providing them with €1 billion to €4 billion more than is required to meet all their liabilities.

Even with the net value of NAMA included, the 2014 debt level will not be more than €210 billion and may be closer to €200 billion. This is truly massive, but the difference between a debt of €200 billion and a debt of €250 billion is material. We could not survive a debt of €250 billion. If we have to carry a debt that large we would be in a similar crisis to one that Greece is now having to face up to.

A €200 billion government debt is massive but it can be carried and does not make default inevitable. Just like in the domestic mortgage market, it is important to distinguish between a borrower who simply can’t pay and one that just won’t pay. Of course, unlike most mortgages we have little intention of ever repaying this debt. We need to get into a position where we can sustainably service the interest costs of the debt.

Greece is bust and cannot carry it’s debt which even in the EC’s baseline scenario is forecast to be close to 190% of GDP by 2014. In Greece the news has been consistently bad. In Ireland we have some positive debt developments since the Morgan Kelly piece in May:

lower bank recapitalisation costs,

lower interest rates on EU loans,

and even a lower 2010 debt because of a DoF accounting error.

By 2014 our debt to GGD ratio will be 114%. Even if we went through the equivalent of the banking crisis again and had to borrow an additional €63 billion for some reason this would bring our debt to around €270 billion which would be 155% of GDP. We would still not be even within touching distance of Greece if the equivalent of the banking catastrophe was to the hit us again.

Greece is bust and their economy is broken. The EU deal on the table does not go far enough and cannot rescue Greece. We can fix the mess we find ourselves in without resorting to the tyranny of default. It will require hard choices but it can be done.